Key Takeaways
- Operating cash flow is the cash generated from a business’ primary operations and is crucial to ensure the organization’s survival and sustainability.
- Key performance indicators (KPIs) and metrics for operating cash flow, such as DSO, DPO, ART, APT, and others, should be closely monitored to ensure enough cash to run daily business operations.
- Benchmarking your operating cash flow metrics against industry standards is crucial to get an accurate picture of how your business is performing.
Introduction
Do you prefer planning for your business on the go or prioritize stability? Effective cash flow management ensures that it provides businesses with the needed capital for their daily functioning, payments to their suppliers, and expansion.
These components boost cash management effectiveness and reflect a broad spectrum of an organization’s financial performance. They identify the right set of cash management metrics because it enables the company to focus on a set of the most significant indicators that correspond to the company’s goals and objectives.
Read further to learn more about operating cash flow metrics that when analyzed can help treasury heads make better decisions with enhanced resource utilization (and increased profitability). So, let’s dive in.
What Is Operating Cash Flow?
Operating cash flow (OCF) is a measure of the cash or net income generated from a business’s core operations, encompassing wages, supplier payments, customer receipts, overhead charges, and non-cash items like depreciation. It plays a vital role in sustaining day-to-day business activities.
Operating Cash Flow Example
For instance, any company’s consolidated cash flow statement is divided into three groups: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Let’s take a real-life example of the 2023 cash flow statement of Coca-Cola.
Here under cash flow from operating activities, we can see the following:
- Amortization of debt cost: This denotes the regular payments that the company makes to repay the loan and covers both the principal amount and the interest charged.
- Fair value adjustment of acquisition-related contingent consideration: It refers to the process of assessing and updating the value of potential future payments tied to an acquisition based on current market conditions and expected outcomes.
- Amortization of intangible assets and deferred proceeds: This means the gradual recognition of the cost of intangible assets and the postponement of related proceeds over time.
- Pension plan settlement expense: It sums up the costs associated with settling obligations or liabilities within a pension plan, typically incurred when transferring pension liabilities to another entity or providing lump-sum payments to plan participants.
- Depreciation expense from property, plant, equipment and financing leaves: It denotes the recorded reduction in the value of property, plant, and equipment over time, including associated financing costs.
Operating Cash Flow Formula
Operating cash flow is a measure of the cash or net income generated from a business’s core operations. The formula for calculating operating cash flow is the addition of net income and non-cash expenses minus the increase in working capital, where net income is non-cash expenses.
How to Calculate Operating Cash Flow?
The calculation for OCF using the indirect method uses the following formula:
- Start with Net Income
- Add Back Non-Cash Expenses
- Adjust for Changes in Working Capital
- Calculate Operating Cash Flow
- Review and Interpret
- Consideration of Other Factors
Operating cash flow = Net income + Non-cash expenses – Increase in working capital
Again taking the example of Coca Cola’s 2023 consolidated cash flow statement and analyzing them we arrive at the following
Net income = $408,375
Non-cash expenses = $153,472 (depreciation expense) + $23,494 (amortization of intangible assets) + $159,354 (fair value adjustment of acquisition-related contingent consideration) + $112,796 (pension plan settlement expense) + $49,021 (deferred income taxes) + $7,181 (loss on sale of property) + $991 (amortization of debt costs) + $0 (deferred payroll taxes under CARES Act) + $0 (impairment and abandonment of property) = $506,309
- Current assets = $1,705,128
- Current liabilities = $1,091,334
- Increase in working capital = $1,113
Given:
- Net income = $408,375
- Non-cash expenses = $506,309
- Increase in working capital= $1,113
Using the operating cash flow = $408,375 + $506,309 – $1,113
So the operating cash flow for Coca Cola for 2023 was $810,690
Key Operating Cash Flow KPIs and Metrics
By tracking the key operating cash flow metrics and KPIs, businesses can identify areas for improvement, optimize resources, and make informed decisions to enhance their operating cash flow. Here’s a list of the key operating cash flow metrics that businesses should track:
1. Days sales outstanding (DSO)
DSO reflects the average number of days a business takes to collect payments after a credit sale has been made.
DSO = (Average receivables in a given period/total credit sales in the same period) x number of days in the period
A low DSO means that your cash conversion cycle is short, and you can collect your dues from customers faster. A high DSO may indicate poor collection practices and cash flow issues.
DSO values vary from industry to industry based on prevalent sales practices. Hence benchmarking your DSO against industry standards is crucial to get an accurate picture of how your collections are faring.
For example, the DSO for the mining support industry is 91 days, while it is only 67 days for the civil engineering construction industry.
2. Days payable outstanding (DPO)
DPO is the average number of days a business takes to pay its suppliers. It can be considered the opposite or reverse of DSO.
DPO = Accounts Payable * the number of days / Cost of goods sold
Cost of goods sold = Beginning inventory + purchases – closing inventory
A higher DPO indicates that you can keep cash in hand for longer and invest it in the short term for better returns but it can also imply that you risk losing good credit terms in the future.
A low DPO often indicates that your business is not taking advantage of the credit terms offered or is not negotiating for better terms. Similar to DSO, DPO also varies from industry to industry.
3. Accounts receivable turnover (ART)
Accounts receivable turnover ratio is the ratio of net credit sales to average accounts receivable for a given time. It provides insights into a business’s collection efficiency.
ART = Total credit sales/ Average accounts receivables
The accounts receivable turnover ratio can be considered a measure of the number of times a company’s receivables are converted into cash in a given time. This ratio is also known as the debtor’s turnover ratio.
A higher ART indicates that a company is good at collecting receivables. A low ART either means that the company has difficulty collecting from its customers or is offering clients payment terms that are too lenient.
4. Accounts payable turnover (APT)
Accounts payable turnover ratio indicates the number of times a company pays its creditors or suppliers in a given time. It is also called the creditor’s turnover ratio and is a measure of short-term liquidity.
APT = Total credit purchases/ [(Starting accounts payable + Ending accounts payable)/2]
A higher APT indicates that your company may not be effectively using your credit terms, or your suppliers may not be extending favorable credit lines. A lower APT suggests that you are using your credit lines effectively; but a very low APT, like a low DPO, can cause friction in your relations with suppliers.
5. Current ratio
The current ratio is the ratio of current assets to current liabilities. It is also known as the working capital ratio and is an indicator of a business’s ability to pay off short-term liabilities.
Current ratio = Current assets (includes accounts receivables) / current liabilities (includes accounts payable and accrued expenses)
A higher ratio indicates that the business can repay its short-term loans easily. A low ratio suggests that the business may have trouble paying its upcoming bills. So, the chance of open invoices turning into bad debt is higher for customer accounts with a low current ratio.
A current ratio between 1.5 – 3 is generally considered healthy. For example, a current ratio of 2 means that the company has twice the amount of cash or assets needed to pay its short-term liabilities.
6. Free cash flow (FCF)
Free cash flow represents the money available to a business to repay its creditors and pay interest and dividends to investors. It indicates the cash available to a business after paying short-term liabilities and investing in the necessary operational equipment.
Free cash flow = Operating cash flow – capital expenditures
A high FCF indicates that the company has good operating cash flow and excess cash to make further investments, pay off debts, or pay dividends to shareholders.
7. Cash flow coverage ratio (CFCR)
The CFCR ratio is the ratio of cash flow from operations to the total debt. It indicates whether a business can pay its debts with the cash flow from operations.
CFCR = [Cash flow from operations/total debt] * 100
A high CFCR indicates that the company is in a good position to pay its debts. The cash flow coverage for businesses should be at least 1.5x. A CFCR of 1.5 indicates that the company has $1.5 in operating cash flows to pay $1 of interest payments.
If the cash flow coverage ratio falls below 1.5, it may suggest that the company has poor debt management practices or that it is struggling to make interest payments on time.
8. Cash conversion cycle (CCC)
Cash conversion cycle, also known as a net operating cycle or cash cycle, measures how long a company takes to convert its inventory and investments to cash. It is measured in days.
Cash conversion cycle = Days inventory outstanding + average collection period (DSO) – DPO
It is a measure of how long every dollar invested in production and sales processes takes to get converted into cash payments. It takes into account how much time the company takes to sell its inventory, collect receivables, and pay its bills.
A lower CCC indicates that the company can collect payments faster and has more liquidity.
9. Operating cash flow margin
Operating cash flow margin is the ratio of operating cash flow to the total sales revenue in a given period. It is a metric used to measure a business’s profitability and the quality of its earnings.
Operating cash flow margin = (Cash flow from operating activities / net sales) * 100
A positive percentage indicates good profitability and operational efficiency. A negative percentage indicates that the company is losing money. Cash flow margin can be used to compare businesses within the same industry.
Timely collections can help have a strong operating cash flow margin. Companies that have an operating cash flow margin above 50% are considered to have a strong cash flow.
10. Forecast variance
Forecast variance measures the difference between your cash forecasts and the actual outcome. Businesses track the variance between their cash flow forecast and the actual cash flow to understand how accurate their estimates are.
Forecast variance = (Actual outcome – Forecast value) / (Forecast value) * 100
Tracking forecast variance over a period helps you improve your forecast models and make better business decisions.
A higher forecast variance indicates that you are not likely to use the right variables in your model or that your forecast model needs a different set of input parameters. A lower forecast variance shows strong predictive capabilities and better decision-making abilities.
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FAQs
1. What is a good cash flow ratio?
A good cash flow ratio is typically considered to be above 1, indicating that a company’s operating cash flow is sufficient to cover its current liabilities. However, the ideal ratio can vary by industry and company size. Generally, a higher ratio indicates better liquidity and financial health.
2. Is cash flow the same as operating cash flow?
No, cash flow and operating cash flow are not the same. Cash flow refers to the movement of cash in and out of a business, encompassing all sources and uses of cash. Operating cash flow focuses on the cash generated or consumed by a company’s core operations, excluding financing and investing activities.
3. What is the operating cash flow ratio?
The operating cash flow ratio measures a company’s ability to generate cash from its core operations to cover its current liabilities. It is calculated by dividing operating cash flow by current liabilities. A ratio above 1 indicates sufficient cash flow to meet short-term obligations.
4. What affects operating cash flow?
Operating cash flow is influenced by sales revenue, operating expenses, inventory management, accounts receivable, and accounts payable. Changes in these variables directly impact the cash generated or consumed by a company’s day-to-day operations.
5. Why is operating cash flow important?
Operating cash flow is crucial as it reflects a company’s ability to generate cash from its core business activities. It indicates the company’s financial health, ability to meet short-term obligations, fund growth initiatives, and pay dividends. Additionally, it provides insights into the sustainability of a company’s operations.
6. What is KPI in cash management?
Key Performance Indicators (KPIs) in cash management are metrics used to evaluate the effectiveness of a company’s cash flow and liquidity management. They include metrics such as cash conversion cycle, days sales outstanding (DSO), days payable outstanding (DPO), and cash ratio, providing insights into cash flow efficiency and financial health.
7. How do you measure cash management efficiency?
Cash management efficiency is measured through metrics like cash conversion cycle, days sales outstanding, accounts payable days, cash-to-cash cycle time, and cash flow forecast accuracy. By tracking these metrics, businesses can identify areas for improvement to optimize cash flow.
